Commentary: The average investor is terrible at timing the market

Data shows that the ordinary retail public — Mom and Pop — are back on Wall Street, and how! According to the Investment Company Institute, the Great American Public has poured $92 billion into the stock market via stock mutual funds since the start of the year.

To put that in context, in the first seven months of last year — when the market was much lower — they withdrew $180 billion.

The last time the investing public jumped into the Wall Street pool with both feet like this was in 2007. And they are investing even more this time around. In the first seven months of 2007 they invested $85 billion into stock funds.

By definition, every stock is owned by somebody, so if Mom and Pop are buying, others must be selling (and vice versa).

And thereby hangs a tale.

According to Dalbar, a Boston-based consultancy that tracks these things, Mom and Pop are just terrible market timers. Year after year, they have a self-defeating tendency to buy when the market has already risen, and sell after it has fallen. They aren’t always wrong, of course, but over time their record is a poor one.

For example, over the 20 years through the end of 2012, Standard & Poor’s 500-stock index produced an annual return of 8.21%. So if you’d invested $100,000 20 years ago and then gone away to a desert island, when you returned you’d find you’d get back your original $100,000 investment, plus a profit of $384,000.

However, over the same period, the average mutual-fund investor — Mom and Pop — didn’t do nearly so well, precisely because they kept buying after stocks had risen and then selling again after they had fallen. Their average return over that period, says Dalbar, was only 4.25% a year. At the end of the period, they would have gotten back their original $100,000 investment plus a profit of just $130,000.

In other words, they missed out on two-thirds of the profits.

The standard Wall Street response to this fact is that one shouldn’t attempt to time the market. For many people that isn’t the worst advice. But I have two caveats, both of which are relevant now.

The first is that advisers usually do tell you to “rebalance,” meaning that when the market rises you should sell some of your stocks and buy more bonds, to restore the original portfolio balance between them, and when the market falls you should do the reverse. That means that if you, say, start out with a balance of 60% stocks and 40% bonds, you should make changes to your portfolio once or twice a year to bring it back into that original balance.

Yet although they never call it that, this strategy is actually market timing. It implicitly recommends you sell the stock market after it has risen and buy it after it has fallen. And data show that in the past it has “worked” — over time, portfolios where you rebalance periodically have tended to produce better returns than those you didn’t touch.

So even the people who say you should never time the market actually think you should time the market, after a fashion.

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This is where “Mom and Pop” investors tend to jump in.

The second caveat is more fundamental. As I mentioned earlier, by definition every stock must be held by someone. So when Mom and Pop buy stocks, they must buy them from someone else, and when they sell them, they must sell them to someone else. Let’s call those other parties “X.” The market rises, Mom and Pop want in, so they buy stocks from X. The market tanks again, and they rush to sell. X buys the stock back.

What we know is that X is timing the market, and he or she is making an absolute fortune. That’s because while Mom and Pop keep buying high and selling low, X manages to buy low and sell high, simply by trading with Mom and Pop.

As I mentioned above, over 20 years, the average investor with $100,000 missed out on two-thirds of his profits. He should have made $384,000, and instead only made $130,000. What happened to that extra $254,000? It went to X, of course.

I can’t read the future, any more than anyone else can. But I know that Mom and Pop have a terrible track record. Over the years, you could have made a fortune just by buying stocks when Mom and Pop sold them and selling when they were buying. And they are buying, heavily, right now.

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